About Ravee Mehta

Former hedge fund analyst and author of The Emotionally Intelligent Investor: How Self-Awareness, Empathy and Intuition Drive Performance. Prior employers include Soros, Karsch Capital and DLJ. Ravee is also a contributor to Seeking Alpha.

Why Stocks Tend To Decline Much Faster Than They Rise

The chart of Caterpillar (CAT) stock from 2002 to 2008 is an example of a cyclical stock that people became enthusiastic about and then subsequently sold in a panic.  Notice how the stock steadily rose from the end of 2002 to the beginning of 2008 and then gave up a substantial portion of those gains in less than a few months.  People generally feel twice as much sadness or pain when something is lost than when something of equal value is gained.  Humans have evolved to be this way, because when the world was more resource constrained, our ancestors’ survival depended much more on keeping what they had than getting something new.  The emotions that arise from loss are from parts of the brain that evolved much earlier than the parts responsible for rational thought.  This is the main reason why stocks go down faster than they go up.  People tend to get depressed and want to capitulate much faster than the time it takes for them to get euphoric.  Furthermore, as a stock rises, many people quickly sell to lock-in their gains.  The shareholder base gradually transitions from distressed and value investors, who contest momentum, to growth investors, who typically invest hoping to ride a trend.  When a stock goes down and its momentum shifts, the only people that would be interested are the distressed or value investors.  Since these types of investors tend to be less impulsive and generally more risk averse, they are usually slow to accumulate shares.  After all, they know that betting against a current trend often results in initial losses.   Distressed or value investors are in no rush to build fully-sized positions.

The above is an excerpt from my book: The Emotionally Intelligent Investor: How Self-Awareness, Empathy and Intuition Drive Performance

A Brief Example Of How To Use Empathy To Get An Investing Edge

The ability to be in the shoes of other investors and feel what they are feeling is an indispensable weapon in the investor’s armory.  Paul Tudor Jones, a billionaire hedge fund manager, affirms that it is less important to understand news than to anticipate the market’s reaction to it. The best way to do so is through empathy.  For example, in early 1990, Jones empathized with the tremendous pressure Japanese fund managers were under to return at least 8% per year.  While it may seem like an aggressive expectation in today’s market, the average Japanese household in 1990 had become accustomed to making at least 8% per year.  Any manager who under-performed that hurdle rate ran the risk of losing his job.  So when the market sold off 4% in January, the Japanese portfolio managers had a choice: they could keep their jobs and still make the 8% minimum return by reallocating aggressively into bonds or they could take a risk on trying to outperform by buying even more equities. [i]  By putting himself in the shoes of the average Japanese fund manager, Jones realized that most of them would not want to risk their jobs.  Consequently, Jones correctly bet that the Japanese stock market would suffer a major correction.

Please see the Disclaimer associated with this blog.  Paul Tudor Jones was not contacted for this and opinions are my own.

[i] Sebastian Mallaby, More Money Than God: Hedge Funds and the Making of a New Elite (Penguin, 2010)

What Most Hedge Fund Leaders Do Wrong

First, let me start off with the disclaimer that while I was a managing director at a multi-billion dollar hedge fund for eight years, I have never actually run a firm.  That being said, I have personal relationships with portfolio managers and analysts at many of the world’s largest hedge funds and believe that most of the leaders of these investment firms do at least one thing very wrong: they do not recognize the importance of their own moods.

There is a tremendous amount of academic research on how mood impacts investing decisions.  When we are happy, we are more inclined to take risks.  When we are euphoric, we can become overly impulsive and overconfident.  When we are sad, we become more risk averse.  When we are depressed, we tend to want to change our lives.  This can result in irrationally undervaluing what we own and overvaluing what we do not have.

A firm’s overall mood fluctuates in correlation to how well or badly it is performing.  When a firm is doing well, the firm’s analysts and portfolio managers will be happier and will ordinarily take on more risk.  Similarly, when a firm is doing poorly, these same employees will be sadder and more risk-averse, all things being equal.  Because markets tend to follow boom and bust patterns, this is usually the opposite of what they should be doing.  Leaders should take advantage of their influence to actively regulate mood swings.  Academic research suggests that the mood of a leader of any group is extremely contagious.  A leader’s mood quickly gets transmitted throughout the rest of the organization.  Therefore, leaders should proactively lift spirits after losses and be more morose when business is going well.  They should put the focus on mistakes and the role of luck during the good times, and on what is being done well during the bad times.  Most CEOs and CIOs do the exact opposite.  They usually make employees feel even worse than they already do for losses, and they overly praise employees for good decisions.  Instead of regulating mood’s impact on rational decision-making, they amplify it.

If you liked this post, you may like my recently published book: The Emotionally Intelligent Investor: How Self-Awareness, Empathy and Intuition Drive Performance.

Daniel Kahneman is Wrong (at least when it comes to investing)

Kahneman’s latest book, Thinking, Fast and Slow, is a must read for anyone interested in how people make decisions. The key takeaway from the book is that there are two different systems that work in parallel. The fast system is based on emotional brain processing and the slower system is based on reasoning. Most of Kahneman’s academic research revolves around how decision making gets corrupted by biases of the fast system. For example, the fast system is biased to believe statements while the slow system can be more cynical. When one is in a happy mood, the slow system, which consumes a fair amount of resources (oxygen, glucose, etc.), puts its guard down and you rely more on the fast system. This is why you are more likely to believe a lie when you are in a happy mood and why you tend to be more cynical when you are sad. As a professional investor, I can relate to this. I find that I am more likely to take risks when I am in a good mood and become more risk-averse when I am in bad mood. While most of Kahneman’s own research revolves around how “fast thinking” causes people to make mistakes, he does recognize that the fast system can actually be better for some situations. For example, chess masters can intuitively and quickly make very good logical decisions. They do not have to slowly evaluate a number of options. Rather, by recognize patterns, they can quickly come up with solutions to chess problems using the fast system. Firefighters and soldiers may also be better off making split second decisions based on what their gut instincts are telling them.

I humbly disagree with Kahneman, a Nobel laureate, and some other prominent psychologists when it comes to “fast-thinking” and investing. They argue that the stock market is too complex and random for intuition to be developed. They believe that the randomness causes people to build incorrect association biases. This argument is flawed.  While the overall market may seem complex and random, there are many patterns within it that recur frequently. The best money managers recognize patterns developing ahead of most. They also can develop useful intuition because they are honest with themselves about the role luck had in their success.  The intuitive decision-making that is involved with investing is much more complicated than other types of decision-making. However, that does not mean that we should abandon trying to better develop and use gut instincts when we invest. Some psychologists, like Gary Klein, also cite the fact that a large percentage of mutual funds underperform market indices every year. To them, this is proof that intuition built from investing experience does not translate into better decision-making. While it is true that most mutual funds underperform, a small percentage outperform consistently, which suggests to me that there is a handful of investors that have a “secret sauce.” Moreover, the fact that many of the statistically best investors seem to come from places where they had similar training (i.e., disciples of Benjamin Graham, Julian Robertson, etc.) implies that the “secret sauce” can be learned.

If you liked this post, check out my book: The Emotionally Intelligent Investor: How Self-Awareness, Empathy and Intuition Drive Performance.